If you are a company contemplating a merger or acquisition with another company, or you just want a better assessment of your financials, a Quality of Earnings (QoE) report could be your answer.
A QoE report is a deep-dive assessment of a company’s financials, with emphasis on the sustainability and accuracy of earnings, identification of potential risks and opportunities, and the evaluation of operational efficiency.
Generally, a merger or acquisition will involve a QoE report conducted by a buyer to obtain a deeper understanding of the company’s earnings and cash flow by providing more information than what is found in financial statements. This information is crucial to buyers, so they know exactly what they are buying, and it’s also a critical element in finalizing a sales price and terms of any purchase/merger agreement.
The QofE process provides insights into the effectiveness of a company’s sales strategy, the demand for its products and/or services, and its overall profitability. Specifically, the revenue recognition, growth, concentration (customer and/or products) and the profitability of the revenue.
A sales analysis may include volume analysis, price analysis, sales mix analysis, and sales trend analysis, depending on the company and the industry.
Understanding of the costs associated with generating the revenue (COGS analysis) and an evaluation of profitability of the revenue (gross margin) over a period of time.
In a COGS analysis, the process might: evaluate trends, the makeup of the costs, compare data against industry benchmarks, and inventory management.
In a gross margin analysis, the process might: analyze gross margin trends, compare against industry benchmarks, and analyze individual product or service margins.
Review of the costs involved in the day-to-day operations of a business. It breaks down each type of operational expense to understand where money is being spent and how it impacts the company’s profitability. This information helps determine the predictability and scalability of a business.
Companies can have income sources and expenses that are not continuing, necessary for the business to continue, and/or not directly related to its core business operations.
Examples of non-operating income sources include interest income, dividend income, gain on sale of assets, and foreign exchange gains.
Examples of non-operating expenses include interest expense, loss on sale of assets, impairment charges, foreign exchange losses, software implementation costs, charitable donations, and lawsuit settlements.
The core business needs operation capital to operate. This operating capital includes current assets such as cash, accounts receivable, inventory, and current obligations such as accounts payable, accrued liabilities, and short-term debt.
During a merger or purchase transaction, it is critical for a company to understand what is needed to operate the business. Having too much or too little working capital can result in a business needing to invest more into the business or overpay for excess working capital.
For mergers, an assessment of a company’s borrowed funds, the associated costs, and any potential risks associated with them may be necessary to evaluate.
Debt review includes debt structure, loan terms and conditions, debt covenants, and credit ratings.
Interest expense review includes interest rates, interest coverage ratio, capitalization of interest, and amortization of debt issuance costs.
An evaluation of a company’s tangible (i.e. accounts receivable, inventory, equipment, buildings, improvements) and intangible (i.e. goodwill, patterns, trademarks) assets, any potential overstated assets, undisclosed liabilities, or unrecorded items.
Liability evaluation includes accounts payable, accrued expenses, debt, deferred revenue, and provisions for liabilities.
Evaluation of a company’s cash inflows and outflows, providing a detailed understanding of how a business generates and spends cash. This analysis provides management and investors with important information as it reveals a company’s ability to sustain operations, pay debts, and fund growth.
This is the process used to adjust a company’s financial statements to remove non-recurring or irregular expenses to allow a more accurate view of a company's profitability.
Examples of non-recurring items include: on-time gains or losses, seasonal fluctuations, extraordinary items, changes in accounting principles, and effects of inflation or currency fluctuations.
The quality of earnings ratio is a financial metric used to determine how much of a company's earnings come from sustained, ongoing business operations as opposed to one-time or non-recurring items.
This ratio provides insight into the reliability and consistency of a company's earnings and helps investors evaluate the overall financial health and stability of the business.
The formula for calculating the quality of earnings ratio is:
Quality of Earnings Ratio = Operating Cash Flow ÷ Net Income
Operating Cash Flow: Cash generated from the company's core operating activities.
Net Income: Total profit or loss reported on the company's income statement.
A high quality of earnings ratio indicates that a significant portion of the company's reported earnings is backed by cash generated from its core operations. This suggests that the earnings are sustainable and less likely to be influenced by temporary factors.
A low quality of earnings ratio suggests that a larger portion of earnings may have come from non-operating activities or accounting adjustments. This may raise concerns about the reliability of the company's reported earnings.
The goal of a quality of earnings report is to provide a detailed understanding of the economic reality of a company, which assists in better decision-making. It can be especially useful to buyers in M&A transactions as it helps in structuring the deal, setting the price, and identifying any potential red flags or deal breakers.
If you are interested in learning more details regarding quality of earnings reports or may be interested in having a report conducted on your business, please contact one of our accounting professionals.